A Political Economic Commentary on Government Finance and Monetary Policy. (Notes and Communications)

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In a provocative essay on state finance, Stephanie Bell (2000) made an important contribution to understanding the institutional details of the US central bank and Treasury operations on bank reserves. My effort in this paper is to flesh out some important implications that were not explicitly addressed in her paper.

Bell presented the following argument. Government spending and taxation have an effect on member bank reserves (MBR). When government spends it adds to bank reserves, and when it taxes it drains reserves from banks. Because daily receipts and disbursements are rarely synchronized, fiscal policy routinely affects reserve levels and the federal funds rate (FFR), which in turn can affect money market rates. To limit the reserve effect, the Treasury and Fed cooperate to maintain FFR stability. Bell argued that bond sales serve as an ex ante and ex post coordination tool so that the government's spending and reserve effect are offset by outflows of funds from banks that are in addition to taxation.

In her section on the "Nuances of Reserve Accounting" (613-615) she made the insightful observation that the government finances all spending via money creation and that taxation destroys money. Since money is the liability of the Fed and these liabilities are discharged when taxes are paid, money is destroyed through taxation. Therefore, taxation and bond sales are reserve maintenance operations, nor financing activities as commonly understood.

What I take issue with is the way she described the role of the Fed (616). She stated that whenever the Treasury is unable to correct an excess of MBR in the system, the Federal Reserve will have to offset changes in the Treasury's closing balance." She went on to write that the Fed's role "as an offsetting agency is essentially forced upon it by its commitment to a target funds rate." Bell cited Poole as stating that Fed policy is "largely non-discretionary."

In her conclusion section (615-617), Bell explicitly referred to a consolidated balance sheet for the central bank and Treasury. While theoretically plausible and valid for her purpose at hand, there is no real consolidated balance sheet. The Fed and Treasury are two separate institutions that affect monetary and macroeconomic conditions. While they do cooperate on policy, they also can and do take independent action. Bell was right that taxes cannot possibly finance government spending as traditionally understood, but this is true whether one looks at consolidated or separate balance sheets. Money is extinguished when offered as tax payments.

I think Bell's point about the Fed should be put more strongly. The Fed sets an FFR target that is substantially positive, and typically their interest rate policy has an upward bias to it, given the price stability priority established by the FOMC. Central banking in part is about maintaining lucrative returns to bond holders by keeping money modestly scarce. The Fed has discretion over the funds target, and it elects to keep rates up. Conceivably, a Post Keynesian central bank would operate differently, acting to drain fewer reserves from the system than a neoclassical central bank. This brings me to my next point.

Bell has clarified the important institutional interaction between the Fed and government and corrected economists' understanding of state finance. In particular, her contribution is to show that modern capitalist governments affect the money supply through fiscal policy and that normal central bank policy maintains an FFR target. Recall The General Theory, in which Keynes sought a way in which to reduce the power of the rentier to keep capital scarce. In his concluding chapter on policy, Keynes argued that investment determines the level of savings and investment is enhanced from a low rate of interest. Yet there is no intrinsic reason for the scarcity of capital that keeps interest rates up to a level which prohibits full employment. …